ECONOMICS 100B Professor Steven Wood03/17/11 Lecture 18ASUC Lecture Notes Online is the only authorized note-taking service at UC Berkeley. Do not share, copy, or illegally distribute (electronically or otherwise) these notes. Our student-run program depends on your individual subscription for its continued existence.These notes are copyrighted by the University of California and are for your personal use only. D O N O T C O P Y Sharing or copying these notes is illegal and could end note taking for this course. LECTURE: Today’s lecture focuses on the Taylor Principle and Inflation Stability. TAYLOR PRINCIPLE:The Taylor Principle says that in order to stabilize inflation, the central bank will raise the nominal interest rate by more than any rise in expected inflation. This way, the real interest rate rises whenever there is a rise in inflation. Failure to follow the Taylor Principle means that nominal interest rates rise by less than the inflation increase, causing real interest rates to fall. This leads to an increase in equilibrium output, resulting in even higher inflation. FAILURE TO FOLLOW THE TAYLOR PRINCIPLE:If there is a temporary negative supply shock, the SRAS curve will shift up to SRAS1on the AS/AD diagram. At the new short-run equilibrium intersection of AD0and SRAS1, output increases to Y1and inflation increases to π1. If the central bank fails to follow the Taylor Principle on the MP curve, an increase in inflation to π1will result in a lower real interest rate r1. The MP curve will have a negative slope. On the IS curve, a lower real interest rate r1translates to higher output at Y1. On the AD diagram, higher output at Y1and higher inflation at π1results in an upward sloping AD curve. Now, because inflationary expectations have increased, the SRAS curve will shift up again from SRAS1to SRAS2. The new short-run equilibrium will be found at the intersection of SRAS2and AD0, with output at Y2and even higher inflation at π2. Overall, as long as the central bank fails to raise real interest rates in accordance with inflation, economic output will continue to increase, as will inflation. Failure to follow the Taylor Principle will lead to increasing economic output and accelerating inflation.
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